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States in Dire Straits as GST Promises Turn Sour

September 7, 2020 | Expert Insights

It was legislation that ensured a 14 per cent growth rate in revenues for States. On a 2015-16 base for five years till 2022, the new Goods and Service Tax regime had clinched the deal for the Narendra Modi Government in 2017. The guarantee of expanded tax revenue, irrespective of the GDP numbers, the GST (Compensation to States) Act 2017 lured even States that were fiercely opposed to it, to sign on.

But in 2020, as tax revenues hit rock bottom, the Centre chose to renege, despite the legislation, on the promise of compensating States for a shortfall in tax revenues. This is alarming for the States as the shortfall is of a whopping Rs. 3 lakh crore between projected revenues and collections for 2020-21 and could debilitate the ability of several States to pay for welfare schemes, in some cases even salaries in the coming months.

After a meeting of the GST Council, the Centre suggested the States could borrow from the Reserve Bank of India, based on future compensation from the Centre, to offset the shortfall. It made a distinction and claimed that only Rs 97,000 crore was the shortfall due to shifting from the earlier tax structure to GST and it was the COVID-19 crisis — "an act of God" according to Finance Minister Nirmala Sitharaman — that led to the rest of the 2.35 lakh crore shortfall!

India’s Opposition-ruled States, like Kerala and West Bengal, have led the charge in questioning the Centre. But even Bharatiya Janata Party- ruled States face a precarious financial situation and are worried about the Centre's refusal to pay up. Bihar, which is ruled by a BJP-Janata Dal (United) coalition, has publicly stated that the Centre is “morally bound” to compensate, and others like Karnataka, ruled by the BJP, have grudgingly agreed to borrow from the RBI. 

GST is a model entirely focussed on taxing at the consumption point and leaves manufacturing States at an inherent disadvantage, and it is the assurance of the Centre, with legislation, that protects their interests.


The GST (compensation) Act does not make any distinction based on the reason for shortfalls, and the Centre's refusal could be challenged by the States in court. However, a Centre versus States battle will be a protracted one. While some Opposition States may follow this path, there needs to be an arrangement for finances in the short term.

In fact, during the pre-2017 GST negotiations with the States, the Centre had guaranteed that compensation for shortfalls would be paid within the five-year period, and States had taken that assurance on face value.

The Attorney General of India himself has been widely reported to have told the Union Government that it has to pay full compensation “irrespective of any shortfall” and that the payments cannot be deferred unless States “agreed” to it. This puts the Centre in an even more difficult position. 

The Centre had sought his opinion on the legality of the GST Council borrowing from the market to make up for the deficit in the compensation fund, which is created by levying a cess on luxury and “sin” goods such as cigarettes and cars.

While suggesting that there is no bar to such borrowing, the Attorney General also suggested that the Centre cannot go ahead and extend such a cess beyond five years if it did not have the concurrence of a majority of the States in the council. 


States can use future compensation as a basis to borrow from the RBI, but they do not want to underwrite such an endeavour. Instead, Kerala’s Finance Minister T. Issac suggested that the GST Council borrow from the RBI directly and compensate the States.

The moot point is that the Centre cannot be absolved of its promise and could underwrite a loan taken by the GST Council to compensate the States.

But the government's precarious fiscal situation — with a deficit as high as 8 per cent for this year — makes it difficult for it to fund the shortfall, and underwriting a GST Council borrowing from the market would be a huge burden on it.

While the pandemic and lockdown did worsen the situation, the Centre was staring at difficulties in compensating as early as the second quarter of last year. The Finance Ministry had told a parliamentary standing committee on finance in August 2019 that the Centre could not pay the State’s share in the current formula. Arguably, this was a crisis in the making that was expedited by the pandemic.


The opposition-ruled States such as Maharashtra, Chhattisgarh and Puducherry have already proposed reverting to the earlier tax system and abandoning the GST mechanism itself. The other States, primarily the manufacturing and more developed ones that had originally opposed the idea could join the chorus, and those that are poorer, and originally supported the idea, may agree to play along with the Centre.

While a reversal of the GST system seems unimaginable now, the pressure is mounting on the Centre to pay up.


  • The compensation law itself does not put the Centre on a strong wicket, and it may find it difficult to pay the price for the "one nation one tax" system. It stands to lose trust if it reneges completely on its promise and risk embarrassment from a legal challenge by the States.
  • Given that the economic situation threatens to be protracted, the compensation burden on the Centre will only increase, and it must find a way out to settle the issue amicably.
  • The issue will further polarise the divide between the Centre and the Opposition-ruled States, and that may be a strain on the federal system itself. In fact, even the BJP States could put pressure on the Centre to pay up, albeit discreetly.